The Simple Reason I'll Never Buy Flotek Industries

The Atlantic hurricane season last year disrupted the operations of many companies in the oil and gas industry, from drillers to refiners and every type of business in between. In that regard, drilling fluid supplier Flotek Industries (NYSE: FTK) wasn't any different from its peers. Its third-quarter 2017 earnings listed the hurricanes as a major impact on its performance during the period.

However, the hurricane season was significantly more devastating for Flotek Industries than most in the industry. In addition to disrupting the operations of its customers, and therefore sales of its own products, Hurricane Irma wiped out an estimated 40% to 50% of Florida's orange crop. That may seem unrelated to oil drilling fluids, but the company needs oranges to manufacture its novel portfolio of chemical additives.

Worse, hurricanes aren't the most pressing threat to citrus crops -- or the company's supply chain. The biosecurity risk facing America's orange crop is the simple reason I won't buy Flotek Industries stock. I understand that may sound a bit ridiculous at first, but it could prove to be an important case study for investors looking to identify biosecurity threats to their investments.

Image source: Getty Images.

Oranges, greening, and one giant problem

Losing half of Florida's orange crop to a single storm is an eye-opener, but hurricanes aren't even the biggest threat to the company's supply chain.

America's orange crop has been in steady decline in recent years from a devastating pathogen called citrus greening disease. First discovered in China in 1943, then South Africa in 1947, it made its way to the United States in 2005. The condition stunts the growth of trees, causes irregular flowering, and yields smaller, bitter-tasting fruits. There is no way to treat citrus greening disease (genetic engineering is the most promising avenue, but the industry is worried about consumer acceptance of GMO oranges), which has scientists worried that the pathogen could significantly reduce the size of America's citrus crop.

While going without orange juice may seem manageable in a worst-case scenario, the problem is more nuanced. Oranges and orange peels are a critical source of citrus oil, which yields important industrial solvents (such as terpene) that are the key ingredients used throughout the company's portfolio of chemical products for consumer, industrial, and energy applications. In fact, Flotek Industries is one of the world's largest purchasers and suppliers of citrus oils.

Unfortunately, citrus greening disease has steadily eroded the supply of citrus oils, sent prices higher, and increased the long-term risk of the company's technology strategy. This matters greatly to investors -- who received a jolting reminder when second-quarter 2017 results were announced. Profit margins were significantly lower due to higher input costs, most of which was traced back to higher costs of citrus oils. And that was before Hurricane Irma made landfall.

Image source: Getty Images.

Management has known about the biosecurity risks in the supply chain for many years now, although it may not be doing enough to protect shareholders. Management thinks the company's leading position in the citrus oils market will allow it to source the volumes it needs despite the souring market conditions caused by citrus greening disease. That may be true, although Flotek Industries may be forced to pay ever-increasing prices for those volumes.

The company is also developing new product formulations to mitigate the price volatility experienced by certain industrial solvents sourced from citrus oils. For example, Flotek Industries would like to reduce the amount of terpene in certain products without sacrificing product performance. Finding chemical alternatives to citrus oil extracts would be prudent, but there are almost always trade-offs when switching ingredients.

So, what can the company do to protect shareholders from citrus greening disease? It's probably unrealistic for Flotek Industries to completely transition away from products that require citrus oils, especially seeing as all of its products rely on the unique properties of citrus oil extracts. That said, diversification could help. The problem is the company had just $56 million in cash on hand at the end of September 2017 -- not enough to make a splashy acquisition.

It may be possible to manufacture the same exact citrus oil extracts in genetically engineered microbes using industrial biotech, rather than agriculture, but that technology strategy is accompanied by problems of its own. Besides, the last time Flotek Industries locked arms with an industrial biotech company it didn't end very well, so it may be hesitant to explore its options.

That leads to an uncomfortable conclusion: Flotek Industries may be unable to escape the risks posed by citrus greening disease.

Investor takeaway

The biggest problem facing Flotek Industries is biosecurity. The most important raw material in the company's supply chain is under pressure from multiple threats (primarily citrus greening disease). Shareholders shouldn't be too confident that management's current strategy will prove to be an adequate response to the problem. Unless and until management finds a way to do so, I won't be going anywhere near the stock.

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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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